The Backdoor Roth IRA

A backdoor Roth IRA allows the owner to convert a traditional IRA to a Roth IRA without income limits. Users are restricted by income limits when contributing to a Roth IRA, but a backdoor Roth IRA has no limits on conversion amounts.(1)

Owners of Roth IRAs pay taxes upfront, but after the taxes are paid, all of the growth and any withdrawals are tax-free to the Roth owner.(2)

The current tax laws allow anyone, regardless of income, to convert a traditional IRA to a Roth IRA with no income limits.Getty Images

The current tax laws allow anyone, regardless of income, to convert a traditional IRA to a Roth IRA with no income limits. The important thing to remember is this will still create a taxable event; after the conversion is done, the money that was converted will count as income, which could place the user in a higher tax bracket in the year the conversion is done.

The advantage of a Roth conversion is that you will pay your taxes today, so withdrawals following current law come out tax-free in the future.(3)

The availability of backdoor Roth IRAs is subject to tax policy and can change at any time.

Two positive features of a backdoor Roth:

The entire Roth account can be inherited by the owner’s beneficiary upon their death without being subject to taxation, as long as the original owner held the account for more than five years.(4)

There are no required minimum distributions during the lifetime of the account owner.

As with traditional IRAs, Roth IRAs were created to help people save for retirement. To be eligible for a Roth IRA, you have to qualify with the income limit of making up to $120,000 a year, depending on your filing status.(5) The backdoor Roth is an opportunity for higher wage earners to take tax-free distributions in their retirement years as well as pass the entire amount of money in the Roth plan to future generations after the death of the Roth owner.

A backdoor Roth is simply a conversion of a traditional IRA to a Roth IRA. Everyone is able to roll as much money from their traditional IRA into their Roth IRA as they want; even if the funds in the traditional IRA exceed the yearly contribution limits on IRAs, you are able to roll over the whole account into a Roth. It is important to remember when doing this that the taxes that have not been paid on the traditional IRA must be paid at that time, and those funds will count toward income.

As we should all be aware with a Roth IRA, taxes are paid upfront, but distributions are then tax-free. With the tax codes being lower this year, a backdoor Roth might be beneficial for some higher wage earners.

Backdoor Roth IRAs might not always be available. As with all tax policies, rules are forever subject to change. To open a new Roth IRA, you are subject to income limits: If you are filing single and make less than $135,000 a year, you will be able to open a new Roth IRA.

Financial expert Ed Slott has four warnings for clients who utilize the backdoor Roth strategy:

1. The client must have earned income; otherwise, they will not qualify to make a non-deductible IRA contribution.

(The backdoor Roth IRA benefit can be doubled for married couples who file a joint return. Spouses who do not have income are still able to qualify, even if they don’t meet the earned income requirement, as long as they file a joint return and their spouse has enough income to cover the contributions for their spouse. It is important to remember the non-working spouse cannot be over age 70 ½.)(6)

2. If the client is 70 ½ or older, the backdoor Roth strategy will not work because there are age limits for making traditional IRA contributions. Even though Roth IRAs do not have age limits, the actual contribution is being made to a traditional IRA, not a Roth IRA.(6)

3. The pro-rata rule will apply. All owned IRAs, including SEP and SIMPLE IRAs, are included in the pro-rata calculation. However, this only means that some of the conversion may be taxable, so your Roth conversion in this process may or may not be tax-free, depending on whether you have other IRAs.(6)

4. The funds that are converted to the Roth IRA through the backdoor IRA will be converted funds, not Roth IRA contributions. This is important to take note of for clients under the age of 59 ½. These clients must wait five years for penalty-free access to those funds because the funds went in as conversions. If the funds went in as Roth contributions, they would be accessible immediately, tax-free and penalty-free.(6)

Another important feature of a Roth IRA is there are no required minimum distributions (RMDs) during the lifetime of the account owner. This allows the entire amount of a Roth account to be passed down to beneficiaries without a taxable event.

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